Qualiport

[ April 3, 2000 ]

The Mismanaged Franchise

Carburton Street, London --My proposal of Games Workshop(LSE: GAW) for the Qualiport caused much angst from Foolish readers over the last week. Although having taken a bit of a slating over on the Qualiport discussion board for even daring to suggest the company, I have to admit that, in my own contrarian way, I still genuinely consider Games Workshop to be a sound investment proposition.

Let me try to explain the reasoning that led to the suggestion of Games Workshop in the first place. Perhaps there is method in my madness. Or maybe, I am just mad.

Firstly, some background to the Qualiport and the current investment climate is needed.

The Qualiport aims to buy quality companies at reasonable prices, and hold on to them for the long-term. Potential Qualiport candidates should ideally possess these ten criteria. Although, in reality, it's unlikely we'll ever find a company that meets all ten. As the Qualiport aims to hold for the long-term, the one point I'll probably never bend is the "identifiable future growth prospects". All the historical long-term winners have all had ample opportunities to further their revenues and profits. As Bruce mentions in the Qualiport criteria:

"You ideally want to invest in a company that is generating strong sales growth. Although we like companies with strong and increasing margins, there will always ultimately come a point where a company is as lean and efficient as physically possible, and margin growth will stop. At that point, only by increasing its top line (sales) will the company be able to continue to grow."

Where do we look for the fastest growing revenue opportunities? Well, in "the industries of tomorrow" -- telecommunications, IT, microchips and so on.

To me, in the current investment climate, it appears investors are still paying for revenue growth at any price. Everybody knows about the growth prospects for the flat loudspeakers, mobile phones, e-commerce software and so on. All these growth opportunities are well and truly recognised by the stock market.

Investors have three options. They can either put on their rose-tinted spectacles prior to paying for material, but "recognised" sales growth, pay a fair price for pedestrian sales prospects, or hunt around for rather more obscure and debatable opportunities.

Given our never-ending fixation on valuation, our dislike for anaemic revenue generators (eg Unilever(LSE: ULVR)) and until "recognisable" growth opportunities fall significantly from the valuation stratosphere, I guess it does the Qualiport no harm to look at prospects where material future revenue streams are perhaps less obvious.

So why Games Workshop?

Firstly, the prospects for their miniature soldiers have been hotly debated on the Qualiport discussion board. Will computer games eradicate the wargaming scene? Who really knows? But let's consider for now that, horror of horrors, wargaming isn't the equivalent of a mid-eighties typewriter.

One reason for selecting Games Workshop was the fact it had little direct competition. That is, little competition in the way of other wargaming companies. Yes, there are other attractions for a spotty teenage boy's pocket money, but when it comes to wargaming, there's only one choice.

The "cheap" valuation for Games Workshop occurred through a lack of financial and operational discipline within the company (In fact, it was through too much sales growth that the operational problems began to occur). But, even with all the underlying problems within the company, the company's dominant position within its niche market remained solid. No mould-breaking new entrants had entered the market place and Games Workshop customers were still buying their products. The "franchise", I felt, was still intact.

GEICO

This concept of buying a mismanaged franchise was put to good use by Warren Buffett in the 1970s, when he purchased his first significant stake in GEICO. What may surprise Fools who may not be entirely familiar with Buffett's stock picking history is that GEICO was on the brink of the abyss at the time of his purchase, after five long years of mismanagement.

GEICO, now wholly owned by Buffett's Berkshire Hathaway(NYSE: BRK.A), is predominantly a motor insurer. During the 1960s, GEICO stood head and shoulders, in terms of its financial performance, over the competition. There were two reasons for this superiority. Firstly, GEICO concentrated on low-risk drivers, such as government employees. Secondly, GEICO operated a direct operation. It cut out the expensive agency intermediaries.

Back in 1960s, competing US insurers couldn't resist taking onboard "riskier" drivers in the pursuit of "growth". Of course, their comeuppance followed soon after, when the newly recruited drivers on their books started to claim. Not only did these other insurers have a greater volume of claims, but they couldn't, or wouldn't, dispose of the costly agency sales route. All good news for GEICO.

With motor insurance primarily a commodity product, the lowest cost operator always won. And in the US during the 1960s, that was GEICO. But as the 1960s turned into the 1970s, so GEICO fortunes dimmed. In 1970, GEICO underestimated the provision for future claims. An underwriting operating loss, the first for many a year, was incurred. In came new management, and a vain attempt to grow out of the reserve problems.

Extracts from Robert G Hagstrom's book "The Warren Buffet Way" succinctly relay the fall from grace.

"In 1972, the company (GEICO) embarked on an expensive and ambitious decentralisation program that required it to make significant investments in real estate, computer equipment and personnel.... By 1973, the company lowered its eligibility standards. Now GEICO's drivers, for the first time, included blue-collar workers and drivers under twenty-one, two groups with chequered driving histories. By the second quarter of 1975, GEICO continued to report losses and announced it was eliminating the company's $0.80 dividend."

"In 1972, GEICO's share price reached an all-time high of $61. By 1973, the share price was cut in half and in 1974 it fell further to $10. In 1975, when the board announced the project losses, the stock dropped to $7. Several stockholders, charging fraud, filed class-action suits against the company. Executives at GEICO blamed inflation and outrageous legal and medical costs for the company's woes. But these problems confronted all insurers. GEICO's problem was that it had moved away from its successful tradition of insuring only careful drivers."

A firm of consultants was drafted in to investigate the extent of the mess. They announced that an injection of capital was needed to keep GEICO from going under. And a new GEICO chairman, John Byrne, was appointed in 1976.

Back to Hagstrom: "Soon after Byrne's appointment, the company announced a $76m preferred stock offering to shore up its capital. Shareholders had lost hope and the stock drifted to $2 per share. During this period, Buffett quietly and doggedly purchased stock in GEICO. As the company teetered on the edge of bankruptcy, he invested $4.1m in the company."

What's this? Warren "I look for a consistent and superior operating performance and turnarounds seldom turn" Buffett buying a company on the verge of receivership? Well I never!

Apart from determining just how near to bankruptcy GEICO was, I'm certain Buffett didn't pay too much attention to the historical financials of the company. There was no point. Returns on equity and cash flows went out of the window. The archetypal investor ignoring recent financial performance as well? Heresy!

So, what on earth led Buffett to place his faith into a company, undergoing a traumatic and costly restructuring exercise, with a then unproven manager at the helm?

Buffett later said that GEICO was not terminal, but only wounded. The "franchise" aspects of GEICO still existed. Safe drivers still existed, and the concept of direct motor insurance still existed too. The historical competitive strengths could still be brought to the fore. GEICO could still be the lowest cost provider. GEICO still had sustainable and competitive advantages, although these were completely obscured through the former management mishaps.

Hagstrom again:

"GEICO's troubles in the 1970s had nothing to do with a diminution of its franchise. Rather the company, because of operating and financial troubles, became sidetracked. Even with no net worth, GEICO was still worth a lot of money because its franchises were intact".

And that's the point -- its intangible franchises were still intact. But you couldn't tell that from the corporate accounts. There was no entry on GEICO's balance sheet suggesting a value for its unique direct car insurance infrastructure. While investors focused on the dire finances and the management abilities of yesteryear, Buffett concentrated on the business fundamentals. All GEICO needed at that time was someone to get a firm grip on the unique underlying strengths of its business. Buffett bought as soon as fresh managerial blood was pumped into GEICO.

A Parallel.

And so a parallel is drawn with Games Workshop, a franchise in the wargaming world undergoing operational difficulties as it evolves into a medium sized business. The company has taken on board a new Financial Director, and a boardroom reshuffle quickly ensued. Then, a significant operating charge follows in the next set of results. Is someone finally getting a firm grip on the underlying strengths at Games Workshop?

Games Workshop isn't on the brink of bankruptcy, but certainly there's has been a realisation and an admission of the large logistical problems within the company. These difficulties aren't insurmountable. Financial performance has suffered in the last few years, and will suffer in the next few couple as well. But what I'm sure hasn't suffered is the intangible niche franchise Games Workshop will always possess.

Note
The Qualiport was launched on December 19th 1997 with an initial investment of £4040.63, all in Rentokil Initial. Further cash was added as holdings in Emap, Marks & Spencer and Unilever were bought during 1998. The vagaries of the value per share accounting method caused percentage return calculations for calendar 1998 to be somewhat distorted. To avoid confusion and somewhat misleading figures, the Qualiport's returns are being measured from 1/1/99, at which point the total portfolio value, including cash, stood at £16,809.60. An additional £2000 cash is added to the portfolio on April 1st and October 1st each year. The total cash investment in the portfolio to date has been £20,184.62. To access the Qualiport's total trade history, click here.